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Monday, July 27, 2015

What Could Be The Catalyst For A Netflix Crash?

Summary
  • In this article, I discuss what could trigger a crash for Netflix stock price.
  • Netflix does not have a moat, nor economics of scale.
  • Two companies could negatively impact Netflix's business.
  • I discuss how investors should act to benefit from this market mispricing.
In the past weeks, Netflix (NASDAQ:NFLX) share price experienced an impressive jump, fueled by the 7:1 split and the better than expected subscriber growth released in the last quarter results. Once again, investors fell in love with the subscriber numbers and chose to ignore the cash flow burning as well as the rising content costs.

Actually, the market does not seem to realize how the company is overvalued and wants to focus only on the positive subscriber growth. Netflix currently trades at stratospheric multiples. But one question remains : when will the party come to an end ? what could trigger a Netflix crash in the following months ?

First of all, Netflix bulls like to point out the company has an economic moat to justify its current valuation. However, I have to disagree. Netflix does not have a moat contrary to popular beliefs among cheerleader investors and analysts.

Economic moat

From investopedia, an economic moat is:

The term economic moat, coined and popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.

Don't get me wrong, Netflix is not a bad company. They release nice content for their subscribers and are continuously expanding it to reach a larger audience. But, Netflix' success story has been built around the premise that they will always release successful content to fuel their subscriber growth around the world. But, what will happen when House of Cards and Orange is the New Black fade ? It is extremely difficult to stay on top and build quality content year over year. In fact, the company latest production Marco Polo seems to be a flop in the making, despite strong early interest from the public. In order to sustain its future growth, the company will have to create future blockbusters but at what cost ?

To build quality content, you need to attract the best in class producers, players and so on. How do you attract the best in class ? You offer them more money than the competitors.

Before Transparent, Amazon (NASDAQ:AMZN) Prime TV streaming was lagging way behind Netflix in terms of blockbusters and original content but will it last forever ? The market thinks so. I could not disagree more. In fact, Amazon starts to invest in content to build best in class series for its Prime subscription. Hulu and HBO are doing the same. Therefore, Netflix has to spend more than its rivals to stay on top. If it spends more on content and acquisition costs, it will never make massive profits, as expected by the current share price. When the market realizes it, the stock price will sink.
Right now, Content and acquisition costs are rising faster than revenues. I expect this trend to continue in the future due to the increasing competition among paid streaming providers. The bull argument is to say that Netflix can decrease its acquisition and content costs thanks to its rising number of subscribers, hence they will lower their per subscriber content cost. While this hypothesis is correct in theory, it does not last because they will have to spend much more money in the future due to increasing competition to defend their position.

The economics of scale

Netflix does not have an economics of scale at its disposal, contrary to Amazon. In fact, Amazon Prime bundles streaming service, music service and a delivery service. Question : how many Netflix subscribers are also Amazon customers ? I guess a lot. This is where Netflix has another major problem going forward: it cannot bundle its offering with something else. By bundling its offerings, Amazon can lure more customers into its ecosystem because they will inevitably save more money by using Amazon services over Netflix. It seems obvious that if you get a TV streaming, a music streaming service and on top of it, a reliable delivery service for your purchases through Amazon shop, for a $10 fee per month, you will never come back to Netflix, which costs 2 dollars less, only for TV streaming service.

On top of it, Netflix has absolutely no pricing power going forward because competition will increase. In competitive industries, the price is a key factor to retain your customers and to get new ones. Furthermore, Amazon has deep pockets to invest in its content initiatives and will certainly match Netflix's offering in the near future in terms of quality and quantity. In my opinion, This is another important factor that the market seems to not take into account to value the company: Netflix has no pricing power.

Icing on the cake for the bears : Apple Streaming TV

According to Macrumours, Apple (NASDAQ:AAPL) could release a refresh of its long due Apple TV and a streaming service to go along with it. The service could compete head to head with Netflix.

With the recently launched Apple Music, it does make sense for Apple to release a similar service for TV streaming with original content. This offering could potentially slow down the growth of Netflix and impact other streaming players as well. Indeed, Apple has a strong competitive advantage in everything it does thanks to its ecosystem and brand. Furthermore, the company has the pockets to attract the best talents.

Conclusion

At these levels, Netflix is definitely a good short candidate. I do believe the risk/reward is appealing. Netflix is priced for perfection. The company trades as there is no serious competition going on and that Netflix will deliver massive profits in the near future. I could not disagree more. The company could easily lose as much as 50% of its market cap, when the bubble bursts. I plan to buy some puts ATM and OTM (exp. January 2016) when the volatility decreases. But I will definitely buy some puts before August end at the latest. At this price, any bad news for Netflix will have a significant downside impact.

Disclosure: I may initiate a short position in NFLX in the following weeks.

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